Belmont Club

The Euro Crisis as a Model for State Debt

Two articles profitably read in tandem are the New York Time’s description of mounting state debt and the Economist’s roadmap of how a country may leave the Euro.  The profligacy of some of the several states, says the NYT, means that “some state and local governments are so distressed that some analysts say they are reminded of the run-up to the subprime mortgage meltdown or of the debt crisis hitting nations in Europe.”

Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country. …

It is the long-term problems of a handful of states, including California, Illinois, New Jersey and New York, that financial analysts worry about most, fearing that their problems might precipitate a crisis that could hurt other states by driving up their borrowing costs.

Some of these states are hiding their debts, delaying payments to suppliers, going slow on tax refunds and paying their employees in I.O.U.s. How it may all play out — at least in Europe — was described by the Economist, where the major focus of decoupling between the bankrupts and the solvents is through the currency. Basically, risks are going to be isolated by reviving the national currencies in the event of a Euro-wide collapse.

While an I.O.U. from the State of California may act a form of local currency, it is unlikely to have value in, for example, Maine. States cannot replace the US dollar as medium of paying external debt. Since the burdened states can’t print their own currency and revalue their obligations in that way, one outcome is that the states may default or negotiate a write-down with their creditors.

When that happens, everybody takes a hit. Not only do the creditors take a haircut but the defaulting state loses capacity to borrow. Citizens who relied on state services or their pensions are going to find the value of these drastically reduced. The NYT says it is already happening . New York and New Jersey eased their budget shortfalls by delaying or trimming pension payments. But that only scratches the surface of the problem.

States and municipalities currently have around $2.8 trillion worth of outstanding bonds, but that number is dwarfed by the debts that many are carrying off their books.

State and local pensions — another form of promised debt, guaranteed in some states by their constitutions — face hidden shortfalls of as much as $3.5 trillion by some calculations. And the health benefits that state and large local governments have promised their retirees going forward could cost more than $530 billion, according to the Government Accountability Office.

The main reason not to worry, according to the NYT, is that the Federal Government can be counted on to bail out the states. ” Moody’s issued a report explaining why it now rates all 50 states, even Illinois, as better credit risks than a vast majority of American non-financial companies. One reason: the belief that the federal government is more likely to bail out a teetering state than a bankrupt company.” Although the states in financial trouble cannot print money, they can do so indirectly, by getting themselves into such a hole that the Federal government will do it for them.

But as the Euro crisis showed the bailout process can only go on for so long. Sooner or later States which have kept their budgets under control will resist picking up the tab, however indirectly, for the morally hazardous behavior of the free-spenders. That suggests that default may be delayed, but not indefinitely commuted, by bailouts. Sooner or later, States which spend more than they pull in are going to take an economic hit.

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